Apple needs the next iPhone to solve a giant financial headache

Apple's various product lines have increasingly stalled over the years, as a chart from Guggenheim Securities shows.

Only its Services business (apps, music, etc.) has remained healthy.

Apple has cut itself off from the lucrative ad businesses that fuel Google and Facebook.

Thus the next iPhone release cycle has a huge task in front of it.

Apple will unveil its next-generation iPhone (expected to be called the iPhone 8 or the iPhone Edition) on Tuesday, and a chart from Guggenheim Securities analyst Robert Cihra gives you a good idea of the giant headache Apple needs that new phone to solve.

The graph is interesting because it shows Apple's business in a seldom-seen way: It charts only the revenue growth of the company, broken out by product.

The chart does a good job of showing how Apple's various product lines have increasingly stalled over the years. In each of the past four years, Apple had one or more major product lines with shrinking sales. That came to a head in 2016, and Apple's overall revenue went into decline for the first time.

Guggenheim

Note that in 2016, Apple's worst year, the only division growing revenue was Services — apps, content, and software in iTunes.

The stakes for the next iPhone — and the expected iPhone 7s and iPhone 7s Plus upgrades — couldn't be higher. If Apple's new phones don't grow revenue, then the company as a whole doesn't grow. The task facing Apple is not trivial. As this chart from Deutsche Bank shows, the iPhone tends to grow more slowly than the smartphone market as a whole — and the smartphone market has flatlined. The next iPhone cycle needs to buck that trend:

Deutsche Bank

Apple's only growing business is Services.

If this were any other company, Services would be growing even faster because Apple could have built a huge advertising business around the music, TV, movies, and apps that pass through the Apple ecosystem, as Google and Facebook have done on their platforms.

Though Apple still sells some advertising (in Apple News for instance), the company has largely eschewed the ad business. In December, Apple killed iAd, its ad network for apps. The symbolic message of that decision — "we don't care about ads!" — was probably greater than its financial effect. Apple never really embraced advertising the way Facebook and Google have. Apple's philosophy has always been to sell consumers a good product and to protect their privacy, and advertising and privacy rarely go hand in hand.

Apple's problem, therefore, is that it has a product business in decline but can't add advertising revenue to cushion the blow. Guggenheim's Cihra describes it this way:

"Apple can't make it up on advertising, since in contrast to consumer Internet companies like Alphabet (GOOG, NC, $922.90) and Facebook (FB, NC, $171.18), whose very business models are based on giving away their service for free to then monetize users via advertising, Apple's customers already paid up for their products. So any follow-on services need to justify their added cost, which is one of the reasons we expect Apple to heavily promote its unique strengths in augmented reality (AR)/ARKit and start spending on exclusive original TV content for its streaming subscribers."

Cihra believes the next iPhone will be the solution Apple needs. That will make the company more dependent on the iPhone. (It also explains one advantage for Apple at setting the price of the device near $1,000 a unit — Apple needs to squeeze more money out of each iPhone than it has before.) Cihra estimates that new iPhones will drive 66% of Apple revenue growth over the next few years, up from 62% historically. "But we see Services contributing the next 25% of Apple's growth, as its second-largest business (we estimate 13% going to 15% of revenue)," Cihra said.

"We estimate Services consistently adding 2% points to Apple's annual revenue growth and 3-4% points of annual profit growth through FY20E," he wrote in a note to clients recently.